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Raise income tax to tackle escalating energy prices

Michael Waterson, Professor of Industrial Economics, University of Warwick

Energy prices seem seldom out of the news. Politicians show their
frustration with the energy market in proposing various solutions.

This week Tory grandee and former prime minister John Major has called for a tax on energy companies. Last month at the Labour Party conference Ed Milliband proposed a 20 month price freeze. And last year, David Cameron had his own stab at “solving” the energy market, proposing that each company should be restricted to a single tariff in order to facilitate choosing between competing firms.

It is easy to sympathise with these attempts to tackle an issue of
considerable and understandable concern to voters. But they rely on
limited understanding of the domestic energy market. Consumers are not
switching their supplier much, partly because it is boring and (to some
extent) difficult; they would prefer “the market” to solve the problem
by assuring them they are not being ripped off with expensive tariffs.

But the market is not very competitive, and proposals to limit
companies’ range of action are likely to have the incidental impact of
rendering it even less so. It’s not the only market in which consumers
get poor deals - the savings industry is another. But consumers spend a
significant proportion of their budget on energy, and price hikes
of up to 10% have become almost routine, blowing a hole in many
consumers’ budgets. This is not a market where prices can be frozen for
long without real consequences.

Have costs increased?

Companies, predictably, say that costs have increased, or are due to
increase. Actually, it’s remarkably difficult either to demonstrate or
disprove this claim, so far as input costs are concerned, for two
reasons. One is that the companies buy a portfolio of future contracts
in order to ensure that the wholesale supplies they will have are enough
to meet future demand. So the only way to keep a rough track on this is
to assume a particular portfolio structure over time and plot the
difference between this and retail prices, as Ofgem does.

But there is a second feature. The wholesale market is by no means
transparent because all six major electricity suppliers are also major
generators, selling to themselves. So to keep track it’s necessary to
examine profitability across both stages. This lack of transparency is
what creates significant difficulties for potential new players on the
supply side, in principle a rather competitive business. So it’s
difficult to assess whether the companies are “too” profitable overall.

Follow the money

What we can say, roughly, is where the money has gone, after the
event. One thing the big six have been obliged to do by Ofgem for the
past couple of years is publish accounts with some separation of costs.
The most interesting of these (because the most potentially opaque) are
the accounts for domestic electricity retailing; those for 2012 are the most recent available.

They show that all the companies spent roughly half the revenue they
got from domestic electricity consumers on their fuel costs. They then
spend around 20% on distribution and transmission costs - these are
regulated elements of cost. The bit that is least clear is their “supply
costs” - the costs of running their retail operations - because these
contain a variety of items including marketing costs and a profit
margin. In total, though, these are perhaps 10% of the revenues.

The companies also claim they need to invest in new generation
facilities, so need some headroom in prices. There is some truth in
this, because our old and dirty power stations are coming towards a
forced end to their life. There is truth also in their claim that
increasing amounts are being added to the bill by imposed environmental
measures, themselves proposed by the government. These include the money
they are forced to spend to try to make our homes better insulated,
plus the money they in effect pay out to subsidise solar and wind
generation. Emissions and environmental costs added 11% to the typical
bill in 2012, and the bad news for consumers is that this element is set
to rise over time.

Supply gap

So one government aim, concerned as we must be with the potential
impact of global warming and the influence of fossil fuels, is pushing
policies that raise energy prices to consumers. But voters have a
short-term interest in seeing low prices, and an increasing proportion
find themselves in fuel poverty. It really is an intractable issue, made
worse by the increasingly wide gap between rich and poor in this
country. It is not going to improve.

Governments have dithered about how to meet the inevitable supply gap
created by decommissioning old coal and nuclear power stations, and in
this sense the recent agreement over the Hinkley Point C
nuclear power station is welcome news. But the power it will supply is
going to be very expensive; around double current wholesale prices.

With this deal, plus governmental subsidies for wind and solar power,
we are moving away from a market for wholesale power towards a managed
system. It is also an inherently less reliable system - wind and solar
power is not flexible - so needs backup from gas power stations and
other more rapid response facilities, which requires investment. So
long-term power needs will be assured only at high prices.

An unpopular solution

Moves to open up the wholesale market, although not headline
grabbing, are the best way to inject more competition into the retail
market. But because the retail profit margins are modest, there is
limited headroom for lower prices from this source; a 5% fall would be
at the optimistic end of the spectrum, and of course the other pressures
discussed above are all in the other direction, and are larger. So
increased competition at the retail level is unlikely to increase
downward pressure on wholesale prices much.

In sum, my view is that the energy market is an area which exposes
the increased income inequality that Britain has experienced for some
years now. There are very many people in the UK who find it difficult or
impossible even now to afford their energy bills and unfortunately I
think this will only increase, given the price pressures.

Therefore, in my opinion, an even more difficult political decision
needs to be made - deliberately reduce inequality and even out the
income distribution by raising income tax and increasing transfers to
the poor, in order to make the higher energy costs more affordable for
all. Subsidies for energy would be a short-term fix, not a long-term
solution.

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Comments

Energy is assumed to be cheap for the consumer allowing him to waste without concern, energy being a loss-leader for other industrial enterprises ... which are all loss-making, by the way.

This dynamic 'works' when energy supplies are plentiful, but the outcome is accelerated depletion which in turn leads to fuel poverty. Believe it or not, the hard limits to non-renewable resources are now heaving into view.

The solution is to stop subsidizing waste with credit and end the loss-leading regime altogether. Replace it with a husbandry approach that rewards conservation rather than finances continual waste. Fuel should become extremely expensive -- particularly motor fuel -- and today's speculative assets such as real estate should become very cheap. The way to do this is swap incentives and subsidies so that credit and taxes are used to bid up energy prices while mortgages and insurances are prohibited.

The alternative is for the entire economy of the British Isles to heel over and capsize under the burdens of real estate credit speculation and fuel waste ... something that is underway right now. As 'bad' as things are in the UK right now you have no idea how 'bad' they will become without serious change of approach.